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What is a Stock Split?
A stock split is a corporate action in which a company increases its number of outstanding shares into multiple shares to boost liquidity, among other reasons. The stock split causes the price per share to decrease for forward splits, but the overall value of the company remains unchanged.
For example, in a 2-for-1 stock split, an investor who owned 100 shares at $50 per share before the split would own 200 shares at $25 per share after the split. The value of the investor’s position will still be $5,000, but they will now own more shares at a lower price.
How do Stock Splits Work?
Stock splits increase the number of shares in circulation by issuing new ones to existing shareholders. A company will decide the split ratio – i.e., 2-for-1 or 3-for-1 – that suits them the best depending on the purpose of the split and the target price they would like to reach for the shares.
All shareholders before the split will have their shares multiplied by the ratio, but the stock price will be reduced proportionately so that the market capitalization stays the same. A company’s market capitalization is calculated by multiplying the total number of shares by the current share price.
After a split, the company’s financial reports will be adjusted accordingly. For example, metrics like earnings per share and book value per share will be affected as the number of shares in circulation will increase. The calculation of the company’s dividends per share will also be impacted and will have to be re-estimated.
Why do Companies Perform Stock Splits?
There are several reasons why managers decide to split their stock.
Here’s a summary of the most common ones:
- Increase Liquidity: A higher number of shares outstanding can improve the liquidity of a stock and make it more attractive to investors or meet the criteria of investment funds. A minimum trading volume is often required by funds to consider a stock eligible to make it into their portfolio.
- Attract More Investors: Lower stock prices allow retail investors with modest available investment budgets to purchase round lots (usually 100 shares) at a reasonable cost. Psychologically, buying more shares feels better, even if the total dollar amount invested is the same.
- Reach Price Targets: Young growth companies that experience large share price run-ups can declare splits to try to keep their shares within an affordable price range. Tech companies use this strategy frequently.
- Reflect Confidence: Stock splits may communicate the management’s optimism about the company’s future. Investors can interpret a split as a sign that the company expects to see its stock price increase in the future and is preparing accordingly by not letting the price go up to unnecessarily high levels.
Types of Stock Splits
There are two main types of stock splits: forward stock splits and reverse stock splits.
Forward Stock Splits
Forward stock splits increase the number of outstanding shares and decrease their price. They are considered bullish splits as the price has risen to the point that a split was needed.
Reverse Stock Splits
Reverse splits decrease the number of shares outstanding and raise the share price. Companies utilize reverse splits when their stock price has decreased substantially, generally under $1 per share.
A low price increases the risk of being delisted from an exchange. Reverse splits allow companies to remain compliant with listing requirements.
Many investment funds are not allowed to consider stocks that trade below $1 – also known as penny stocks – or over-the-counter (OTC) securities – those that are not listed in an exchange.
Reverse splits are considered to be bearish as they indicate that the value of the company has decreased over time to the point that they need to raise the price artificially just to remain listed.
The Stock Split Ratio
The stock split ratio compares the number of shares owned before and after the split. For example, a 2-for-1 forward split ratio means that an investor would own twice as many shares at half the price after the split is completed.
Some common stock split ratios are:
- 2-for-1
- 3-for-1
- 5-for-1
- 10-for-1
Effects of Stock Splits
Stock splits may temporarily impact the share price due to increased demand from retail investors. However, in the long run, the effect is minimal because the fundamentals of the business stay the same. Splits do not impact the quantitative value of a company or its financial performance.
Stock splits indicate that the management team expects further price increases, but economic downturns and unexpected business setbacks can stall momentum and ultimately reduce the share price despite the split.
The Bottom Line
Stock splits directly increase the number of shares you own. While psychological and liquidity changes can occur, investors should focus on a company’s fundamentals, not the number of shares they possess, to analyze if the stock is trading at an attractive price at the time.
